Microeconomic Theory:

Basic Principles and Extensions 11e

Christopher Snyder | Walter Nicholson

PowerPoint Slides prepared by: Andreea CHIRITESCU - Eastern Illinois University

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 Economic Models

PowerPoint Slides prepared by:

Andreea CHIRITESCU
Eastern Illinois University
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
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 Theoretical Models
• Economic models
– Used by economists to describe economic
activities
– Most are abstractions from reality
– Provide aid in understanding economic
behavior

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 Verification of Economic Models
• Two general methods used to verify
economic models:
– Direct approach
• Establishes the validity of the model’s
assumptions
– Indirect approach
• Shows that the model correctly predicts real-
world events

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 Verification of Economic Models
• We can use the profit-maximization model
to examine these approaches
– Is the basic assumption valid? Do firms
really seek to maximize profits?

– Can the model predict the behavior of

real-world firms?

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 General Features of Economic
Models
1. Ceteris Paribus assumption
– “Other things the same”
– Economic models explain simple
relationships
• Focus on only a few forces at a time
• Other variables are assumed to be
unchanged

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 General Features of Economic
Models
2. Optimization assumption
– Economic actors are rationally pursuing
some goal
• Consumers: maximize utility
• Firms: maximize profits (or minimize costs)
• Government regulators: maximize public
welfare
– Generate precise, solvable models
– Optimization models appear to perform
fairly well in explaining reality
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 1.1 Profit Maximization
• A firm can sell all the output that it wishes at
a price of p per unit
• Total costs of production, C, depend on the
amount produced, q
• Profits = π = pq – C(q)
• The profit-maximization output level, q*
• First-order condition
• Output level for which price is equal to
marginal cost, C’(q)
• Second-order condition
• Marginal cost must be increasing at q*
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 1.1 Profit Maximization
First-order condition: 
d 
 p  C '(q)  0 or p  C '(q ) 
dq 

Second-order condition: 
d 2 
2
 C "(q )  0 or C"(q*)  0 
dq 
d ( p  C '(q*)  0) dq *
 1  C "(q*) 0
dp dp
dq * 1
  0
dp C "(q*)
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 General Features of Economic
Models
3. Positive-normative distinction
• Positive economic theories
– Seek to explain the economic phenomena
that are observed
• Normative economic theories
– Focus on what “should” be done

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 1.1
Structure of a Typical Microeconomic Model

Values for exogenous variables

are inputs into most economic
models. Model outputs (results)
are values for the endogenous
variables.

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 The Economic Theory of Value
• Early economic thoughts on “value”
– “Value” was considered to be synonymous
with “importance”
– The price of an item may differ from its
value
– Prices > value were judged to be “unjust”

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 The Economic Theory of Value
• The founding of modern economics
– The wealth of nations by Adam Smith is
considered the beginning of modern
economics
– Continuation of distinction between value
and price
• Value meant “value in use”
• Price meant “value in exchange”

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 The Economic Theory of Value
• Labor theory of exchange value
– The exchange values of goods are
determined by the costs of producing
them
• Primarily affected by labor costs
– Diamond-water paradox
• Producing diamonds requires more labor than
producing water

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 The Economic Theory of Value
• The marginalist revolution
– The exchange value of an item is
determined by the usefulness of the last
unit consumed
• Since water is plentiful, consuming an
additional unit has a relatively low value

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 The Economic Theory of Value
• Marshallian supply-demand synthesis
– Supply and demand simultaneously
operate to determine price
– Prices reflect both the marginal valuation
that consumers place on goods and the
marginal costs of producing the goods

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 1.2
The Marshallian Supply–Demand Cross

Price
Equilibrium
S
QD = Q s The supply curve has a positive
slope because marginal cost
rises as quantity increases

P*
The demand curve has a
negative slope because the
marginal value falls as
D quantity increases

Quantity per period

Q*
Marshall theorized that demand and supply interact to determine the equilibrium price
(p) and the quantity (q) that will be traded in the market. He concluded that it is not
possible to say that either demand or supply alone determines price or therefore that
either costs or usefulness to buyers alone determines exchange value.
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 1.2 Supply-Demand Equilibrium
• Quantity demanded = qD = 1000 - 100p
• Quantity supplied = qS = -125 + 125p
• Equilibrium  qD = qS
1000 - 100p = -125 + 125p
225p = 1125
p* = 5
q* = 500

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 1.2 Supply-Demand Equilibrium
• A more general model is
qD = a + bp
qS = c + dp
• Equilibrium  qD = qS
a + bp = c + dp
ac
p* 
d b

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 1.2 Supply-Demand Equilibrium
• What happens to the equilibrium price if
either demand or supply shift?
• An increase in demand (an increase in a)
increases equilibrium price
• An increase in supply (an increase in c) reduces
price
*
dp 1
 0
da d  b
dp 1 *
 0
dc d  b
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 1.2 Supply-Demand Equilibrium
• A shift in demand will lead to a new
equilibrium:

q’D = 1450 - 100p

q’D = 1450 - 100p = qS = -125 + 125p
225p = 1575
p* = 7
q* = 750

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 1.3
Changing Supply–Demand Equilibria

Price An increase in demand...

S
…leads to a rise in the
equilibrium price and
7 quantity.

D’
D

500 750 Quantity per period

The initial supply–demand equilibrium is illustrated by the intersection of D and S (p*

= 5, q* = 500). When demand shifts to qD’ =1; 450 - 100p (denoted as D’), the
equilibrium shifts to p*= 7, q*=750.
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 The Economic Theory of Value
• Paradox resolved
– Water
• Low marginal value
• Low marginal cost of production
• Low price
– Diamonds
• High marginal value
• A high marginal cost of production
• High price

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 The Economic Theory of Value
• General equilibrium models
– The Marshallian model is a partial
equilibrium model
• Focuses only on one market at a time
– For more general questions, we need a
model of the entire economy
• Must include the interrelationships between
markets and economic agents

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 The Economic Theory of Value
• Production possibilities frontier
– Can be used as a basic building block for
general equilibrium models
– Shows the combinations of two outputs
that can be produced with an economy’s
resources

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 1.4
Production Possibility Frontier

Quantity of food Opportunity cost of

(per week) clothing = 1/2 pound of food

A
10
9.5
Opportunity cost of
B
clothing = 2 pounds of food
4
2

Quantity of clothing
3 4 12 13
(per week)

The production possibility frontier shows the different combinations of two goods that can be produced
from a certain amount of scarce resources. It also shows the opportunity cost of producing more of one
good as the amount of the other good that cannot then be produced. The opportunity cost at two
different levels of clothing production can be seen by comparing points A and B.

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 The Economic Theory of Value
• Resources are scarce
• Scarcity  we must make choices
– Each choice has opportunity costs
– Opportunity costs depend on how much of
each good is produced
• Welfare economics
– Concerns the desirability of various
economic outcomes

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 1.3 A Production Possibility Frontier
• An economy produces two goods, x and y
• Labor - the only input
• Production function for good x: x=lx0.5
• lx is the quantity of labor used in x production
• Production function for good y: y=2ly0.5
• ly is the quantity of labor used in y production
• Total labor available: lx + ly ≤ 200
• Production possibilities frontier:
lx + ly = x2 + 0.25y2 ≤ 200

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 1.3 A Production Possibility Frontier
• Opportunity cost of good y in terms of good x
• x2 + 0.25y2 = 200, or y2= 800 - 4 x2, or

y  800  4 x 2

• If we differentiate, we get
dy 2  0 .5  4x
 0.5(800  4 x ) ( 8 x ) 
dx y
•When x = 10, y = 20, dy/dx = -4(10)/20 = -2

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 1.3 A Production Possibility Frontier
• Concavity
• The slope of the frontier becomes steeper (more
negative) as x output increases and y output
decreases
• When x = 12, y  15, dy/dx = -4(12)/15 = -3.2
• Inefficiency
• Economy operating inside its production
possibility frontier
• 20 workers are permanently unemployed
• x2 + 0.25y2 = 180
• When x = 10, then y  17.9
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 The Economic Theory of Value
• Welfare economics
– ‘‘Economic efficiency’’
– Conditions under which markets will be
able to achieve it
– Clarifying the relationship between the
allocation pricing of resources
• Properly functioning markets provide an
‘‘invisible hand’’ that helps allocate resources
efficiently

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 Modern Developments
• The mathematical foundations of
economic models
– Clarification and formalization of the basic
assumptions that are made about
individuals and firms
• New tools for studying markets
– Creation of new tools to study markets

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 Modern Developments
• The economics of uncertainty and
information
– Incorporation of uncertainty and imperfect
information into economic models
• Computers and empirical analysis
– Increasing use of computers to analyze
economic data and build economic
models

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